Are Rising Vacancies A Concern?

When the housing market began to seriously falter in 2006, analysts raised concerns that retail real estate would be next. It was no secret, after all, that millions of Americans had pulled equity from their homes for years to finance cars, vacations and shopping trips to the mall.

But the industry proved the pundits wrong.

Cash registers kept ringing in spite of the deflating housing bubble--although sales growth did dip slightly in the past six months. (Same-store sales growth has averaged about 2.3 percent each month so far this year.) More importantly, the retail real estate sector boasts strong fundamentals. Property values in markets across the United States are at or near all-time highs. And, the retail development pipeline is swollen.

However, it seems, troubles are looming on the occupancy side. At the end of the second quarter, vacancy rates at neighborhood and community shopping centers hit their highest level in nearly four years, according to Reis Inc. The vacancy rate climbed 10 basis points to 7.3 percent during the quarter, making it the ninth consecutive three-month period of flat or declining occupancy.

"We feel that the availability rate is rising because consumers have turned circumspect due to the slowdown in the housing market and that their spending is being affected by high gas prices, so retail space absorption is declining," says Abigail Marks, an economist at CBRE Torto Wheaton Research. Completions are also outpacing demand compounding the problem.

Other retail industry data providers' figures support those reported by Reis. In its mid-year review, CoStar Group saw a rise in the national vacancy rate to 6.8 percent, up from 6.6 percent at the end of the first quarter. Vacancies have risen each quarter since CoStar began tracking retail in the first quarter of 2006.

Meanwhile, absorption--or the change in the amount of leased space--fell to 3.1 million square feet; also its lowest level in 4 years. The situation isn’t expected to improve before the end of the year. Developers are set to deliver more than twice as much new retail space in the second six months of the year as they did in the first. Altogether, 26.2 million square feet of new space is expected to hit the market; up from 11.4 million square feet in the first half of the year. (According to CoStar, developers delivered 661 centers containing 20.3 million square feet to the market in the second quarter.)

While much of this space has already been leased, Reis' chief economist, Sam Chandan predicts it will push the national vacancy rate up even further--to 7.6 percent--its highest level in 12 years.

“The projected imbalance between net absorption and completions will increase the upward pressure on retail vacancy rates, as well as on concession levels for new and renewing tenants,” says Chandan.

Bernard J. Haddigan, senior vice president and managing director of Marcus & Millichap’s national retail group, says the pre-leased new construction is helping to keep the effects of the consumer environment at bay.

“From an operational point of view, it’s been a fairly healthy year so far. In the short term, we’re not really seeing a strong impact yet," he says.

Still, some retailers have revised downward their number of store openings for 2008 and 2009. Wal-Mart announced it would build less than 200 Supercenter stores in 2007, compared with its initial plans for 270. Also, Office Depot said it would slow its expansion plans due to softer sales of furniture, office supplies and technology items.

This could be particularly worrisome with the 209 million square feet of space in development, according to CoStar Group. In 2007, 188.2 million square feet will open--the most ever by a long shot. The second highest year for deliveries was 1986 with 156.1 million square feet.

Is it time to hit the panic button? The answer from brokers and developers so far is a resounding "No."

While vacancies have crept upwards, landlords retain a strong hand in the lease negotiation process. Deep concessions that prevail in weak environments--such as prolonged periods of free rent, substantial tenant improvement allowances or even rent decreases for renewals--are not on the table.

For now, the data providers see concessions as being stable--about 9 percent of asking rents--and that's not expected to change in the second half of the year or going into 2008. In fact, rental rates continue to trend upwards. According to CoStar, rents quoted at the end of the second quarter were $17.76 per square foot-- up 3.3 percent over the first quarter.